A good is not traded, if its domestic price is too high to be exported (at world market price, exchange rate, international transport costs and the other factors given), but too low to be imported. (Other reasons for goods being non-tradables are mentioned in Annex B1 above).

Table B2-1: Impact of changing trade parameters on categories of tradables

3. Exchange rate and current account balance

The exchange rate itself is nothing else than a price, too, namely the price of foreign currency. Foreign currency is required to pay for imports, and it becomes available through exports. If the market for foreign currency were free (in many developing countries this is not the case, see below), the exchange rate would be determined by supply and demand factors as with any other commodity. If the value of exports equals the value of imports, the current account is in balance and the exchange rate remains unchanged (abstracting from other factors influencing the overall balance of payment situation and the exchange rate, such as capital imports, foreign credits, other foreign capital transfers). If the value of imports exceeds the exports, we have a current account deficit, and the demand for foreign currency (to pay for imports) exceeds its supply (export earnings in foreign currencies exchanged .by the exporters into local currency). In this situation, the price for foreign currency, hence the exchange rate, tends to rise (if it is allowed to do so), meaning a depreciation of the local currency in relation to foreign currencies. As result of the increased exchange rate, the domestic prices of importables as well as exportables will increase. In response to these price changes, the demand for imported goods and overall imports are likely to go down, while the production of exportables and the volume of exports are likely to increase. Both effects, diminished imports and increased exports, tend to bring about a new equilibrium in the market for foreign currencies and a balanced current account.

The condition for a balanced current account, expressed in local currency, is given by the following formula:

iii)

where Qx/m stands for the quantity of export/import items, and Px/m,lc for the domestic prices of tradables (determined by the world market price, local currency equivalents at current exchange rate applied). Using formula 1) above, the condition for a balanced current account can also be expressed in foreign currency equivalents:

iiia)

If both sides of the equation are not equal, we have a current account surplus (Left>Right), or a current account deficit (LR), the exchange rate would fall (appreciation of the domestic currency), and the domestic prices of tradables would fall accordingly. In response to these internal price changes, the domestic production of tradables is likely to go down (see Box A-1 in Annex 1), hence exports are likely to go down as well, while the imports will increase (lower production of importables is substituted by increased imports, and the effect on the production side is compounded by increased demand due to lower prices, see Box A-2 in Annex 1). These movements work towards re-establishing a balanced current account.

The same mechanism works, as already described, in the other direction in the case of a current account deficit (L Formula 3a) points to a third important factor,(other than a fixed exchange rate and insufficient domestic production of tradables), being responsible for an unbalanced supply and demand of foreign exchange, and hence a current account deficit: the world market prices of importables and exportables. Many developing countries have suffered a worsening of their terms of trade, i.e. a deterioration of their export prices in relation to the prices of imports. From formula 3a) it can be easily deduced that current account deficits are an inevitable consequence of such a situation. Collective adjustment, i.e. efforts of various countries to promote exports of the same commodities, are likely to reinforce this trend.

4. Effects of a fixed overvalued exchange rate

Contrary to the ideal of a free market economy (see Annex 2A), the governments of many countries have decided not to allow a free floating of the exchange rate according to the market forces of supply and demand, but to keep the exchange rate fixed, usually at a rate below the real exchange rate which means an effective over-valuation of the domestic currency. A principal reason for this policy is to fight inflation which would be accelerated by rising prices of imports resulting from a devaluation. Other reasons may be the interest of influential groups in getting access to cheap imports or to foreign exchange at favourable rates.

An overvalued exchange rate has a number of crucial consequences on the macro-meso economic level of the economy:

• It leads to a perpetuation of a trade and balance of payment deficit (see Salter-Swan-model in Annex 2A).
• It implies a divergence between the nominal and the equilibrium exchange rate, as well a between the nominal and the real exchange rate. The equilibrium rate and real exchange rate are closely related but differently defined: the first is the level of the exchange rate which brings about a trade balance (see above), while the latter is a measure of a country's exchange rate against the currencies of other countries over time, adjusted for the difference in the rates of inflation between the countries. If the rate of inflation in other countries is lower than in the country concerned, the equilibrium rate as well as the real exchange rate will tend to rise above the initial fixed nominal rate (which means an effective overvaluation of the local currency).
• It has depressing effects on the domestic prices of tradables (importables as well as exportables), leading to distortion in price structures and inappropriate price signals to producers as well as consumers. The price effect of an overvalued currency is often referred to as a negative indirect rate of protection (see Annex 2D).
• As the nominal exchange rate does not lead to a balance of supply and demand of foreign exchange, it requires official regulation and restrictions of the foreign exchange market and gives rise to the emergence of parallel markets, with additional administrative costs and associated risks of corruption and market distortion (see below).

Figure B2-1: Balanced and unbalanced market of foreign exchange

In order to maintain the nominal exchange rate below the equilibrium rate, additional foreign exchange must be made available through foreign credits or a depletion of the country's foreign exchange reserves. If these possibilities are exhausted, administrative measures become necessary to restrict imports (e.g. through import licenses) and to control the foreign exchange earnings from exports (in order to make sure that the foreign exchange from export earnings is offered at the nominal rate on the official market).

In a situation of unbalanced supply and demand, a parallel market for foreign exchange is likely to arise, with exchange rates well above the nominal rate. As the parallel market exchange rate is more attractive for exporters (and any owners of foreign exchange who want to change into local currency), the quantities of foreign exchange offered at the official rate will further decline (shift of the supply curve of foreign exchange available on the official market from S to S'), and the gap between supply and demand for foreign exchange will further increase. On the other hand, importers who fail to obtain import licences are forced to buy foreign exchange at the higher parallel market rates.

As a result of a multiple exchange rate system with official and parallel market rates, we get a highly distorted price and market structure:

• relatively low prices of products imported at the official rate compared to the prices of products imported at the parallel market rate (even for the same type of goods);
• extra profits for importers who manage to obtain import licences and to obtain foreign exchange at the favourable official rate (which they may share with officials in charge of issuing import permits);
• higher prices and extra profits for exports bypassing official channels.